Netflix: Finally Emerging From The Upside Down

Seeking Alpha2022-10-30 09:54

Netflix

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Summary

Netflix is undertaking a fundamental change to its business model through its ad-supported plans and monetizing of account sharing.

The potential growth in smart TV sales is also a strong catalyst for the company.

From a valuation perspective, however, the stock offers very limited upside at current levels.

Investment Thesis

Netflix (NASDAQ:NFLX) has given us some fantastic stories over the years but there were not enough reasons to cheer for its stock, especially in the recent past. In this article, I argue why that has changed now, thanks toits revamped business model.

Streaming Ad Sales are Likely to Be in Demand Even as Economy Slows

Netflix management, during the Q3 earnings, shed more light on their new ad-supported streaming plan. The plan, which is expected to launch in 12 countries next month, will be priced 20-40% below the current starting plan. In the United States, this would translate to a monthly subscription price of $6.99 compared to today's starting price of $9.99. To put things in context, Disney's (DIS)ad-supported Disney+ plan will be priced at $7.99 a month in the U.S. and is expected to launch only in December. So not only is Netflix launching a month in advance, but the company has also undercut its strongest competitor. Moreover, Netflix's ad plans will have approximately five minutes of advertising per hour, a minute longer than Disney's, which in the grand scheme of things, is negligible.

The ad-supported plan, if you are to believe Reed Hastings and Co., is attracting a lot of initial demand from advertisers. During the earnings call, Greg Peters, the company's Chief Operating and Chief Content Officer, talked about how the company had to decline offers from interested parties because they currently don't have the capacity to keep up with the demand. This shouldn't come as a surprise given that advertising video on demand (AVoD), according to Magna Global, is expected to help ad sales grow 33% in 2023, amounting to $6.3 billion.

Although at the start, from advertisers' perspective, Netflix's plan will most likely have only basic targeting capabilities, a point that management duly acknowledged, the potential of this model, especially with the decline of traditional TV, is too strong to be overlooked. Even if ad growth slows next year on account of the expected economic slowdown, which is also what Magna Global predicts, expect advertisers to continue to target users of Netflix and Disney+. The opportunity on these streaming platforms is too big to ignore, even during uncertain times.

Monetizing Account Sharing can be a Game Changer

In addition to an ad-supported plan, Netflix management also announced that they would be monetizing account sharing and they aim to roll this update out in early 2023. This was an expected move given that one of the biggest challenges faced by the company was people sharing their Netflix account passwords with their friends and family members. This is about to change next year with subscribers expected to pay an additional fee for sharing their account with individuals outside their household.

The management, during the earnings call, announced that it would introduce the ability for current borrowers to transfer their existing Netflix profile on the borrowed account, into their own accounts. The individuals who are currently sharing will also have the ability to create sub-accounts for those individuals that are currently borrowing.

As long as the company prices this new feature correctly, I am of the opinion that it is going to be a substantial source of new revenue. It's likely to sting at the beginning, there could be a drop in subscribers, but given the content that's coming out from the company, it's hard to imagine that the current borrowers are going to stay away for too long.

Don't Forget the Catalyst that is the Growth in Global Smart TV Sales

In addition to the actions taken by the management, there is an external catalyst for the company, which is the potential growth in the global Smart TV market. The more smart TVs that are sold, the higher the probability of an increase in Netflix subscribers.

The global Smart TV market is not only growing but is set to explode in the coming years. According to Grand View Research Inc., this market is expected to reach $451.30 billion by 2030, growing at a CAGR of 10.9% from 2022 to 2030. In the United States, the number of connected TV users is expected to grow from 185 million in 2020 to 201 million in 2025. According to Statista, the internet-connected TV penetration in the U.S. currently stands at 87% in 2022. This figure stood at 50% in 2014. Furthermore, the share of adults watching a video, weekly, via a connected TV device in the U.S. rose from 10% in 2011 to 60% in 2021.

The growth opportunities for Netflix are clearly visible, not just in the U.S. but across the globe. Also, imagine the addressable market for all those advertisers who want to partner with the company!

Valuation

Source: Refinitiv, Author's Projections, and Company's Q3 Press Release

The company expects Q4 revenues to come in at $7.8 billion and operating margins to be in the range of 4 to 8%. Given that the company is expected to face the bulk of the FX impact in Q4 and given that Q4 is traditionally when the operating margins come in light due to higher marketing spending, I was very conservative and assumed that operating margins will be 4%. The operating income for FY22 then amounts to $5.39 billion.

Assuming interest expenses don't change in Q4 and assuming that the company manages to see a 3% gain in other income on account of FX gains (similar to Q3), this would translate to total EBT of $5.6 billion.

Assuming an effective tax rate of 16%, net income would come in at $4.7 billion. According to Refinitiv, the number of shares outstanding stands at 445.02 million. This results in an FY22 EPS of $10.56.

According to Refinitiv, the company currently trades at a forward P/E of 28x, which when you compare it to its peers, is expensive (Disney trades at 20x, Paramount Global trades at 11x). While Netflix deserves a premium multiple given its growth prospects, the economic slowdown next year could impede that growth. Therefore, I assumed a multiple of 25x for Netflix, which is roughly the mid-point of where Netflix is trading at present and Disney's forward P/E multiple.

The company, according to Zacks, has a PEG ratio of 1.36, which would translate to an earnings growth of 18.4%. This would put FY23 EPS at $12.50. Using a forward P/E multiple of 25x, we get a price target of $313.00, which suggests a nearly 6% upside to the closing price on Friday, October 28th 2022.

Given this very limited upside, despite my love for the stock, I think there will be better opportunities to get into the stock, especially during these volatile conditions. The average target for the stock on Wall Street is around $279, so there is significant potential for a pullback, which should be a great buying opportunity given the long-term prospects of the company.

Risk Factors

With an impending economic slowdown looming, there is the possibility that its ad-supported plan might run into some troubles right from the start. As I mentioned earlier, Magna Global expects a slowdown in growth in the overall ad sales in 2023, and while it's right to be bullish about ad sales on streaming platforms, one shouldn't discount the possibility that things might not be as rosy as expected especially if the economy takes a turn for the worse.

Then there's the obvious risk of the new ad-supported plan cannibalizing the company's existing plans. In other words, existing subscribers could simply trade down from their current, more-expensive plans to a cheaper plan, thereby eating into the company's revenues. While management doesn't see any switching on the existing plans, it doesn't mean that it can't happen when the ad-tiered plan comes into effect. In fact, I do believe that in countries where the economic situation is murkier, this could very well be the case.

Finally, the company's performance in Asia-Pacificis anything but remarkable. Revenues, paid net additions, and Average Revenue Per Membership all declined substantially year-over-year. While this can be attributed to FX headwinds, there has been a sequential decline in the region for a while now, especially in India. This is an area that the company needs to get a grip on, especially if it needs to see its ad-tiered plan reach its full potential.

Concluding Thoughts

Overall, I am finally warming up to Netflix the stock. In the past, while I enjoyed watching the likes of Stranger Things and Bling Empire, I wasn't really excited about the growth prospects of the company, especially given the tremendous pressure it faced from competition. Until now that is.

The company finally appears to be undergoing a positive fundamental shift given that it is branching out its revenue streams, with the likes of ad-supported platforms and monetizing password sharing. Moreover, the growth potential of ad sales on streaming platforms as well as that of Smart TV sales are expected to be strong catalysts for the company.

However, from a valuation perspective, I am of the opinion that better opportunities will arrive given the limited upside at current levels. Netflix has stopped just chilling and is finally growing up. Now that's a story I can get on board with.

source：Seeking Alpha